How to Determine if a Business Expense Is Deductible

by | Mar 1, 2022 | Accounting, Taxes

As a CPA who provides tax services, I hear a lot of myths, rumors, and “tips”. While much of this advice is well-intended, it actually puts business owners in a very difficult position. Not only can some of this bad advice get a business in financial trouble but it can also lead the business owner to confusion around who to trust. 

One of the biggest myths on the internet surrounding taxes is whatever you charge as a business expense is deductible. While most business expenses are deductible it does not mean you can charge everything in your life to your business.

The IRS explains that a compliant business expense is both ordinary and necessary for the course of business. 

Ordinary

For an expense to be ordinary for the course of business, you should reasonably expect another similar business to be making that purchase. There should not be expenses listed that are strange, outside your operations, or not within the normal course of business.

For example, if you were to own a bakery it would be normal for you to purchase items like flour, frosting, sugar, an oven, aprons, maybe even chairs and decor for your space. However, if you charged personal expenses to the business like a flat screen TV for your home or lawn mower, these are not ordinary expenses you would expect of a bakery.

For them to be considered ordinary the TV should be used in the bakery in some way, maybe to display a menu. Likewise, the lawn mower would only be appropriate if there was a lawn for the bakery to maintain.

These expenses would not be considered ordinary for a bakery but if used appropriately then they can be.

When trying to decide whether a business expense is ordinary, ask yourself whether it would be considered appropriate for another similar business to be making the purchase. 

Necessary

The second part of the IRS rule, necessary, emphasizes that the expense should not be inflated or extravagant for your normal course of business. 

For example, if you were to travel to a conference on the other side of the country it would be considered necessary to classify your plane ticket as a business expense. Even if you upgraded to business class, it could be considered a business expense. 

However, if you were to rent a private jet this could easily be seen as unnecessary.

Continuously come back to the question, is this normal for our type of business and industry?

Examples

There are many areas within the tax code that can be seen as gray. This is one of those areas. While an expense may seem ordinary and necessary to you, it is important to reasonably consider other business owners and their interpretation of your expenses. To further illustrate how to determine whether a business expense is ordinary and necessary, let’s consider another example.

Let’s say you are a self employed real estate agent and you make some of the following expenses. Here is how to determine whether each is ordinary and necessary.

Business Cards and Pamphlets
This purchase would be considered both ordinary and necessary. We can reasonably assume another real estate agent in your area would also be making these purchases for their work, therefore we can expect the expense to be deductible.

Fully Loaded Cadillac Escalade
While a car is certainly needed for a real estate agent, this type of car may be a bit too extravagant and may not apply to the necessary rule. Something to consider is real estate agents in similar situations. If you are selling luxury homes and the expense would be considered fairly normal among real estate agents in similar selling brackets, then it may be acceptable.

New Shoes
This one can be especially tricky, after all it would be considered unprofessional if you showed up at a client site without any shoes on. 

However, clothing can only be considered a business expense if it is uniquely designed to your business. So if the shoes were to have your logo on it or if these specific shoes were needed to complete a job (think construction or laborer workers). For these reasons, new shoes for a real estate agent generally would not be a deductible business expense.

If you own a business it is common for the lines to sometimes become blurred between work and personal. You pour so much time and energy into your business, it may seem like there is no such thing as a personal expense. While it may feel that way, it is important to understand the IRS regulations around what is and is not an acceptable business expense deduction. 

If you are looking at your business expenses for the year and wondering whether some of your business expenses are properly classified, send us a message. We will happily walk you through the process of establishing what is and is not a business expense, as it applies to your business.